Predictably Irrational

We all understand what sunk costs and opportunity costs are. That is our rational being, which usually fails to show up when making everyday decisions. We are susceptible to many different biases that are rooted in emotions than rational reasons. This does not change when we are making purchases for our businesses. One such emotion is our response to buying experience and associating it with product experience.

In my previous articles I wrote about cognitive cost to customers in choosing a version from all available options. The effect of choice proliferation and the cost it imposes has been reported before. A more striking finding was*, the cost incurred at initial purchase remains sticky in the minds of your customers. Worse customers associate this cost with product experience. After a customer makes the purchase, the cost she incurred in making the selection is sunk and hence should have no impact on rest of the product experience. Unfortunately that is not the case.

“emotions could influence how people make decisions even after the heat or anxiety or exhilaration wears off.”

In their experiments, they found that those who had an emotional response carried that emotion even during later rational decision moments. This is because people tap into their memory of decisions made earlier. So if the buying experience is really painful with multiple options to choose from, multiple questions to answer and forms to fill out, your customer is bound to feel annoyed. When someone asks them about product experience, they tap into their memory and recall this annoyed state and give bad overall rating for your product.

The good news from Ariely’s findings is, it cuts both ways. If the customers had a great buying experience its effect is felt long after the initial purchase.

It is not enough for you to focus on product UI and product experience – your buying experience should be exhilarating as well or at least not annoying to the customers.

As I connect with and work with many entrepreneurs from my class at Haas, from Boulder, through my blog and as I read more about them, I am compelled to make a generalization about their mindset and how they approach ideas. I see the doublespeak in my claims, basing it purely on anecdotal evidence, after all my writings on the need for evidence based management and calling out those who make such generalizations. For what it is worth, treat these as hypotheses and not as claims.

Corollary: To start a venture one needs to be risk seeking and at the very least be willing to suspend their rational mind to make the leap.

H2: Most ventures start with an entrepreneur seeing a localized problem and deciding that it needs a generic solution.

Here is a case study (which not should be treated as proof but rather as one of many stories that added to my conviction and pushed me to make the hypotheses).

Netflix for Hot Couture: This is a business started by two Harvard MBAs. One of they saw the problem with women buying expensive evening wear and party wear just for single use and decided that this problem is generic enough and needs a bigger solution. They came up with a web based service for renting designer dresses for $50 to $100. For an analyst this idea is a non-started. Look at all the issues:

The idea is not unique and is easily copyable

What is the problem is this addressing and what is the unique value add?

What is the market size? What are the segments? What is each segment willing to pay?

Fashion by definition is fickle and changes fast and is different across regions – how much inventory does one need and how big is the risk of carrying this inventory?

For a $1000 dress can we rent it out enough times to not only cover the costs but also turn profit?

These alone are enough reasons to not starting this venture but not to the two people who not only started this but have successfully found funding for it. Will this venture go big? My analytical part says no, but as a fellow human I wish them well and hope they will go big and succeed.

The problem with unbundled pricing (pricing separately for each component of a monolith) is the multiple purchase decisions the customer has to make. Every time the customer opens the wallet and pays for an extra, they feel increasing pain (Prospect Theory). Customers will see each transaction as a loss and according to Prospect Theory the pain from multiple small losses can be more than the pain from a single loss of same magnitude. The pain from losses do not increase linearly with amount paid but the pain is felt every time customers have to pay.

Take the case of airline unbundled pricing, specifically the baggage fees. Profit from baggage fee is nothing to be sneezed at. For someone who travels a few times a year and checks-in bags, it is painful each time they pay for bags and leads to brand erosion. United has come up with an innovative way to reduce this pain by reducing number of payments – they now offer an yearly subscription for baggage check-ins for $249.

Forget about first and second bag fees for an entire year. With Premier Baggage, you and up to eight companions can check up to two standard bags each without fees, where applicable, every time you travel in the United States

Premier Baggage also makes a great gift for a frequent traveler.

This is a great pricing plan in many ways:

It addresses the multiple pain instances by reducing payments.

It captures value upfront.

Someone buying this subscription is going to prefer the same airline for the entire year even though they should not (because after they paid the fee it is sunk and they should compare the cost of available options for each trip).

The best possible case for United is people buying it not using it.

The worst possible case is a group of eight companions checking in two bags even once. But in that case they are generating so much revenue from the tickets that it more than makes up for lost baggage fees.

They have a good chance of getting businesses to buy it for their employees or gifting to their clients/customers.

To United there is really no cost, all of this is profit. The only cost is the opportunity cost of lost baggage fee from high volume and or frequent users but that is made up and more from ticket sales.

Every time you see a commercial for casinos, they show seemingly happy people each stating how much they won at the casino. I have all reasons to believe these are true endorsements. Of course what they are not telling us is what their net earnings are after all the money they spent since they started gambling. It is not surprising that the casinos do not want to highlight this, after all they want to only talk about the winnings. But you might find this surprising to hear that in real life, outside of the commercials, neither do the protagonists in those commercials talk about the total amount they lost to gain these winnings. It is human behavior to ignore or downplay the negatives and focus on the positives. This is the same reason that led them to gambling in the first place.

The basic idea is that when people judge their chances of experiencing a good outcome–getting a great job or having a successful marriage, healthy kids, or financial security–they estimate their odds to be higher than average. But when they contemplate the probability that something bad will befall them (a heart attack, a divorce, a parking ticket), they estimate their odds to be lower than those of other people.

This is the same irrational optimism that leads many entrepreneurs to start their venture, despite the market conditions, lack of strategy, lack of competitive advantage and their own lack of wherewithal to execute. Just like the gambler commercials that focus on the winnings, most entrepreneurs tend to focus on the success stories. The two common traits in both are – first, they ignore the opportunity cost of the capital and time they are investing, be it gambling or the new venture and second they strengthen their own resolve to jump in by overestimating gains and underestimating risks.

The result is the big gambling losses and the increasingly high number of start-up failures. All from Predictably Irrational Exuberance.

Like this:

Endowment Effect, introduced by Thaler, states that people tend to value things they own more than they are valued by the market. Hence people are reluctant to let go of things they own at the market price and end up accumulating them. The New York Times magazine profiles the business that is build on this, Self-storage. People are not rational automatons, they are not aware of sunk costs nor are they capable of doing net present value calculations of multiple options. They cannot tell the monetary difference between storing their wares in self-storage vs. selling them now in garage sales at the prices the market is willing to pay.

Clem Tang, a spokesman for Public Storage, explains: “You say, ‘I paid $1,000 for this table a couple of years ago. I’m not getting rid of it, or selling it for 10 bucks at a garage sale. That’s like throwing away $1,000.’ ”

People end up paying $100-$200 per month for storing things that will not even cover the rent if they were to be sold off. The result is a thriving business – self-storage that adds negative value to most of its customers. The question is will we see a return to rationality due to current economic conditions?